Issue 51 • November 4, 2009

One Year Later ... the Credit Crunch Lingers

Credit markets have certainly improved from last year’s crisis and near financial meltdown, no question ... but conditions are still NOT back to “normal” ... not by a long shot.

A stark reminder of this comes from the fact that NINE more banks shut their doors last week — bringing the total to 115 bank failures so far this year — the most since the aftermath of the Savings & Loan crisis nearly two decades ago.¹

In fact, these latest bank failures pushed the already insolvent FDIC deposit insurance fund even deeper into the red. The FDIC (meaning ultimately, taxpayers) had to cough up another $2.5 billion to “resolve” these nine troubled banks.²

In fact, the FDIC fund has already been operating in a DEFICIT balance since September 30. And, that was after the deposit insurance fund shelled out or committed $32 billion in bank bailouts since the crisis began. Even worse, according to its own analysis, the agency expects bank failures to continue through 2010!³

To some extent, these deepening problems in the banking sector were completely overshadowed last week by news that our economy is growing again!

The broadest measure of output in the economy, Gross Domestic Product (GDP), advanced at a +3.5% annual rate in the third quarter, according to preliminary government estimates.⁴

This was slightly ahead of consensus forecasts, which called for +3.2% growth. Never mind that motor vehicle output (thanks to “cash-for-clunkers” ) accounted for nearly HALF of the total increase in GDP growth last quarter, and that this program is now over.⁵

With these lingering issues, can we count on this robust GDP number to repeat in future quarters? And, has the financial storm truly passed, paving the way toward a sustainable recovery? Or, was this just a one-quarter GDP wonder ... with demand artifically created by government stimulus?

To help answer this question, let’s turn to a potentially even more troubling story about another financial failure early this week ...

CIT Group, a major lender to small- and mid-size businesses, filed for bankruptcy protection on Sunday. This wasn’t a total surprise, because the lender has been in intensive care since the credit crunch intensified over a year ago.

But CIT’s failure is significant. It is the largest financial failure since Washington Mutual was seized by regulators a year ago. It is also the first lender that had received government bail-out funds to go under ... taking $2.3 billion in taxpayer money down with it.⁶

That’s how much the U.S. Treasury injected into CIT late last year as part of the Troubled Asset Relief Program (TARP) — $2.3 billion. At the time, CIT was deemed “too big to fail”... along with many Wall Street firms ... but evidently, not anymore.

More troubling is the wide impact CIT’s failure could have on businesses throughout Main Street America. Remember, CIT was one of the nation’s biggest lenders to more than ONE MILLION small- and mid-size firms. I’m talking about a vast array of mom & pop businesses – like retailers, restaurants, manufacturers and distributors.

These are firms that are finding it increasingly difficult to access credit these days in order to fund their day-to-day businesses.

In 2007, CIT made almost $40 billion in new commercial loans. The firm financed another $45 billion in trade receivables that year ... but this figure plunged to just $4.4 billion in the first half of 2009.⁷

Last year, CIT was also the top lender for Small Business Administration (SBA) loans, but so far in 2009, the ailing firm originated just $65 billion in SBA loans.⁸

Here’s the problem: small businesses employ HALF of our country’s workforce and account for the bulk of new job creation in America. They also contribute nearly 40% of total GDP. But credit to consumers and small business has contracted by TRILLIONS of dollars as big banks cut their credit lines.⁹

They have never had a harder time getting a loan, and have very limited options to turn to for needed financing in today’s ailing credit markets.

To be sure, large public companies have been able to issue new debt since markets began to stabilize early this year, or have received government TARP funds — sometimes both. Unlike their public counterparts, small businesses are unable to access public credit markets and are finding it increasingly difficult to raise needed capital from other sources.

That’s because big banks — those that are still members of the “too-big-to-fail” club — simply AREN’T making new loans.

Now, U.S. bank lending has declined for the past 21 straight weeks, with total outstanding commercial loans and leases plunging by an astonishing $216 billion over that period. That’s a record 15% yearly rate of credit CONTRACTION — never before seen in ANY recession since records began.¹⁰

This credit contraction has been broad-based across all lines of business: consumer loans ... real estate lending ... and industrial loans. This may seem odd, since the big banks have received trillions in TARP money and other government bailout programs ... not to mention the ability to borrow from the Federal Reserve at near ZERO interest rates.

But rather than making productive new loans, which could help the economy recover on a sustainable basis, banks seem perfectly happy to stash this cash in their vaults ... or play the yield curve ... by borrowing at low rates and reinvesting in slightly higher yielding Treasury securities. So much so that cash on bank’s balance sheets soared by $160 billion last week alone ... and now totals a record $1.3 trillion!¹¹

In other words, more than one year after the Lehman failure ... even with massive government bailouts ... the “velocity” of money in the U.S. financial system — or the money multiplier, as it’s called — is still extremely depressed.

Simply stated, all this liquidity created by the government and pumped primarily into Wall Street may have succeeded in shoring up big banks’ balance sheets ... at least for now.

But most of this money remains trapped in bank vaults rather than finding its way into the real economy and into the hands of credit-worthy businesses desperately seeking financing to remain afloat.

As a result, the current level of money and credit available to the real economy — the one on Main Street — may simply not be enough to sustain a normal business-cycle expansion and lasting recovery.

Of course, all this sounds disturbingly similar to Japan’s economic stagnation over the last two decades.

After its stock market and real estate bubbles popped in 1989, Japan’s big banks and major corporations suffered a massive shock to the system. In response, they refused to lend, hoarded cash, and were saddled with staggering bad debts that took many years to fully recognize and write-off.

Last year, major American icons followed suit, including Citigroup, General Motors, AIG, Merrill Lynch and General Electric, suffering a similar shock to the system. Many were bailed out by Washington. Small and mid-sized businesses, unfortunately, haven’t been so lucky. Apparently, they are “small-enough-to-fail.” Let’s hope not.

But without access to credit for Main Street businesses and absent government stimulus, sustained GDP growth may prove difficult to achieve going forward. Let’s hope we don’t keep moving down the same path as Japan has been on over the last 20 years. Stay tuned!

Good investing,

Mike Burnick
Director of Research & Client Communications
Weiss Capital Management, Inc.

¹ Bloomberg: Bank Failures Buffeting FDIC Efforts to Bolster Insurance Fund, 11/2/09
² Ibid.
³ Ibid.
⁴ Ned Davis Research Daily Economic Commentary, 10/29/09
⁵ Ibid.
⁶ Wall Street Journal: CIT’s Swoon Hits Taxpayers, 11/2/09
⁷ Ibid.
⁸ Reuters: CIT failure to leave small businesses floundering, 11/1/09
⁹ Wall Street Journal: The Credit Crunch Continues, 10/1/09
¹⁰ Gluskin Sheff Economic Commentary, 11/2/09
¹¹ Ibid.